UNIT – 5

Concept of Factor Pricing:

Factors of production can be defined as inputs used for producing goods or services with the aim to make
economic profit.

In economics, there are four main factors of production, namely land, labor, capital, and enterprise. The
price that an entrepreneur pays for availing the services of these factors is called factor pricing.

An entrepreneur pays rent, wages, interest, and profit for availing the services of land, labor, capital, and
enterprise respectively. The theory of factor pricing deals with the price determination of different factors of
production.

Concept of Factor Pricing:

Factor pricing is associated with the prices that an entrepreneur pays to avail the services rendered by the
factors of production. For example, an entrepreneur needs to pay wages to labor, rents for availing land, and
interests for capital so that he/she can earn maximum profit. These factors of production directly affect the
production process of an organization.

In context of an economy, these four factors of production when combined together produce a net aggregate
of products, which is termed as national income. Therefore, it is important to determine the prices of these
four factors of production. The theory of factor pricing deals with the determination of the share prices of
four factors of production, namely land, labor, capital and enterprise.

In other words, the theory of factor pricing is concerned with the principles according to which the price of
each factor of production is determined and distributed. Therefore, the theory of factor pricing is also known
as theory of distribution. According to Chapman, the theory of distribution, “accounts for the sharing of the
wealth produced by a community among the agents, or the owners of the agents, which have been active in
its production.”

There are two aspects of each factor of production, which are as follows:
i. Price Aspect:
Refers to the aspect in which an organization pays a certain amount to avail the services of factors of
production. For example, wages, rents, and interests constitute the price of factors of production.

ii. Income Aspect:

Refers to another aspect in which a certain amount is received by a factor of production. For instance, rents
received by a landlord and wages received by labor constitute the income generated from the factors of
production.

Theories of Factor Pricing:

The theory of factor pricing is concerned with the principles according to which the price of each factor of
production is determined and distributed. The distribution of factors of production can be of two types,
namely personal and functional. Personal distribution is concerned with the distribution of income among
different individuals.

It is associated with the amount of income generated not with the source of income. For example, an
individual earns Rs. 20,000 per month; this income can be earned by him/her by wages, rents, or dividends.
On the other hand, functional distribution is associated with the distribution of income among different
factors of production as per their functions.

It is concerned with the source of income, such as wages, rents, interests, and profits. In regard of
distribution of factors of production, there are two theories, namely marginal productivity theory and
modern theory of factor pricing.

Theories of Rent
RENTRICARDIAN THEORY OF RENT
David Ricardo, a classical economist developed a theory in 1817 to explain the origin and nature of
economic rent. Rent is the payment made to landlord for the use of land. Ricardo was of the view that rent is
paid for the fertility of land. Ricardo stated “Rent is the portion of the produce of the earth which is paid to
landlord for the use of the original and indestructible powers of the soil.
ASSUMPTIONS
1. Rent of land arises due to the differences in the fertility of the soil.
2. Law of diminishing marginal returns. As the different plots of land differ in fertility, the produce
from the inferior plots of land diminishes though the total cost of production in each plot of land is
the same.
3. Rent accrues only to land i.e. none of the other factors of production earn rent. However later on
Modern economists disagreed on it.
 4. There is tendency to move from most fertile land to the less fertile one.
5. Land on which no rent is earned is known as marginal land.
6. Total cost spent on each piece of land is same
EXAMPLE: There are 6 grades of land – I, II, III, IV, V, VI. The classification is on the basis of fertility. A
is most fertile. The fertility of soil is known by its production. Most fertile soil will have more production
and consequently more value of output. So the column of value of output is indicator of fertility of the soil.
As mentioned in assumption total cost remains same. Say here total cost = 1000.

As can be seen that Grade I is the most superior land producing maximum output of 5000 on which Rent
earned is 4000. Similarly Grade II land earns 3000 and so on. This shows direct relation between the value
of output and rent earned thereof keeping the amount spent on land same on every piece of land . On Grade
V land Amount spend = Value of output i.e. Total rent is 0. This is Marginal land. Grade VI land will never
be cultivated as the Value of Output is NIL.
Highest Rent = On Grade I land i.e. Most superior piece of land
Marginal land = Grade V land where Amount spend and Value of Output is Equal i.e. ZERO RENT
Land left uncultivated = Grade VI land as the value of output is nil and Amount spent is 1000 so it is
irrational to cultivate it.
CRITICISMS OF THE THEORY
1. Modern economist are of the view that rent doesn’t arises on the land alone.
2. Rent is not paid on account of its fertility of the soil but due to its scarcity.
3. Ricardo said that the most fertile land is cultivated at first and then we move on to the lesser fertile
land is also not accepted. In reality the land which is closest is cultivated at first.
4. Ricardo said rent is the residual amount left after other factors are paid. But in reality profit is the
residual amount whereas rent is decided before any production activity.
MODERN THEORY OF RENT
Economists like Alfred Marshall, Joan Robinson criticized Ricardian theory of Rent and put forward a new
approach. They believed that rent does not arise due to fertility of the land rather it arises due to Scarcity of a
factor. Although land is free gift of nature but it is not free for a firm or enterprise. They have to pay for its
usage and the price is decided by the scarcity i.e. more scare the factor more price for it. So the availability
of the factor affects its price. Here the concept of opportunity cost comes in play. Opportunity cost is the
value of next best available alternative .A Factor needs to be paid minimum amount equal to its opportunity
cost. Remember it is the minimum amount i.e. the lowest limit, actual amount may be much higher.
The actual amount to be paid depends on the scarcity and availability of that factor. If the factor is scare i.e.
less available then the buyer has to pay more amount (Price) for that factor than its opportunity cost. This
extra payment is nothing but Rent which depends on scarcity of a factor. Similarly for less scare factor buyer
may pay an amount equal or slightly higher than its opportunity cost.
So rent is the extra payment over the opportunity cost (Minimum cost which has to be incurred). The scare
factor attracts more rent as the difference in the opportunity cost and actual rent paid is more.
Ricardo in his theory assumed that rent arises only on land but the advocates of Modern theory of rent
believed that rent can arise on any factor of production.
EXPANATION WITH THE HELP OF EXAMPLE
Suppose an IT professional is working in firm A for a monthly package of Rs.one lakh. With the growing IT
sector, the demand for IT professionals will increase. Now firm B offers him a monthly package of Rs. two
lakh and he accepts the same.
Opportunity cost in above example = 1,00,000
Actual earning of factor = 2,00,000
Rent= Actual earning- Opportunity cost i.e. 200000-100000=100000
The rent of one lakh is result of scarcity of IT professionals i.e. demand of IT professionals are more than its
supply as a result their price increases.
The scarcity of factor can be shown with the help of its Supply curve. If the factor is highly scare its supply
curve will be vertical to the X axis or perfectly inelastic showing zero opportunity cost and whole amount as
rent. On the other hand if the factor is not scare at all supply curve will be horizontal to the X axis or
perfectly elastic one showing that the opportunity cost is equal to actual amount and hence Zero rent.
Theories of Interest

1. Productivity Theory:
According to productivity theory, interest can be defined as a reward for availing the services of capital for
the production purpose.

Labor that is having good amount of capital produces more as compared to the labor who is not assisted by
good amount of capital.

For example, farmer having tractor to plough the field produces more as compared to the farmer who does
not have it. Thus, interest is the payment for the productivity of capital.

Criticism of Productivity Theory

i. Focuses only on the causes for what the interest is paid, not on the determination of interest rates.

ii. Assumes that interest is paid due to the productivity of capital. In such a case, pure interest should vary as
per the productivity of the capital. However, pure interest is the same in money market during the same
period of time.

iii. Lays emphasis on the demand of interest, but ignores the supply side of capital.

iv. Fails to explain how the interest is paid for the loan borrowed for consumption purposes.

2. Abstinence or Waiting Theory:

The abstinence theory was propounded by Senior. According to him, interest is a reward for abstinence.
When an individual saves money out of his/her income and lends it to other individual, he/she makes
sacrifice. The term sacrifice implies that the individual refrains from consuming his/her whole income that
he/she could spent easily. Senior advocated that abstaining from consumption is unpleasant. Therefore, the
lender must be rewarded for this. Thus, as per Senior, interest can be regarded as the reward for refraining
from the use of capital.

Abstinence theory was also criticized by a number of economists. According to the theory, an individual
feels unpleasant when they save as it reduces his/her consumption. However, rich people do not feel
unpleasant while saving because they are able to meet their requirements.

Therefore, Marshall has replaced the term abstinence with waiting and described saving in terms of waiting.
He states that saving is done by transferring the present requirement to the future and the person needs to
wait for meeting those requirements. However, people do not want to wait rather they are motivated to save
money by providing a certain amount of interest.

3. Austrian or Agio Theory:

Austrian theory is also termed as psychological theory of interest. This theory was advocated by John Rae
and Bohm Bawerk in an Austrian school. According to Austrian theory, interest came into existence because
present goods are preferred over future goods. Therefore, the present goods have premium with them in the
form of interest. In other words, present satisfaction is of greater concern as compared to future satisfaction.

Therefore, future satisfaction has certain type of discount if compared with present satisfaction. The interest
is the discounted amount that is required to be paid for motivating people to invest or transfer their present
requirements to future. For example, an individual has to make a choice between two options.

He/she can either have Rs. 500 now or the same amount after a year. In such a case, he/she would prefer to
have Rs. 500 in present. However, in case, the individual has a choice of getting Rs. 500 in present and Rs.
600 after one year.

In such a case, he/she would be more inclined toward getting Rs. 600 after a year. Thus, the extra payment
of Rs. 100 would compensate the sacrifice involved in delaying his/her present satisfaction. The extra
payment of Rs. 100 in the given case is considered as interest.

Criticism
i. Lays too much emphasis on the supply aspect and ignores the demand aspect

ii. Does not focus on the determination of rate of interest

4. Classical or Real Theory:

Classical theory helps in the determination of rate of interest with the help of demand and supply forces.
Demand refers to the demand of investment and supply refers to the supply of savings. According to this
theory, rate of interest refers to the amount paid for saving.

Therefore, the rate of interest can be determined with the help of demand for saving money to be invested in
the capital goods and the supply of savings. Let us understand the concept of demand of investment. Capital
goods are used for the production of consumer goods and provide returns continuously for many years.
However, a certain degree of uncertainty is associated with capital goods due to their future use. In addition,
operation and maintenance costs are involved in using capital goods. This makes organizations to calculate
the net expected return on the marginal cost that is represented as the percentage of cost of capital good.

In case, an organization has similar type of capital goods, then the increase in one more capital good would
not yield them high revenue. The increase in the rate of interest would result in the fall of demand of capital
goods.

Criticism
i. Assumes the full employment of resources, which is not true in reality. This is because if one
resource is reduced from one production process, then it would be utilized for other production
process. On the contrary, if resources are available in abundant, then there is no need to save
them.

ii. ii. Assumes that investment can be increased only when individuals reduce their consumption.
This is because if the consumption is less, then the saving would increase, which would lead to
the increase in investment. However, if the demand of capital goods decreases, then the incentive
to produce capital goods would also decrease. This would result in the decrease of investment.
iii. iii. Assumes that there is no change in the income level of an individual. Thus, according to
classical theory, saving and investment become equal due to change in rate of interest. However,
according to Keynes theory, savings and investment become equal because of changes occur in
the income level of an individual.

5. Loanable Fund Theory:

Loanable fund theory agrees with the view that time preference plays an important role in determining the
occurrence of interest. This theory is also termed as neo-classical theory of interest. According to neo-
classical economists, interest is the amount paid for loanable funds. It focuses on the determination of rate of
interest with the help of demand and supply of loanable funds in the credit market. Let us understand the
concept of supply of loanable funds.

The supply of loanable funds depends on the following factors:

i. Savings:
Act as one of the sources of loanable funds. The loanable funds in the form of saving are classified as ex-
ante saving and Robertsonian sense. Ex-ante saving refers to the saving that an individual plans according to
his/her expected income and expenditure in the starting of a year or financial year or for a month.

On the other hand, Robertsonian sense refers to the saving that is produced by taking the difference of
previous period income and present period consumption. In both the types of savings, the savings are
different at different rate of interest. Savings are dependent on the income level that vanes with the rate of
interest. The increase in the rate of interest would result in the increase of the level of saving and vice versa.

In the context of organizations, the amount left after distributing the profit in the form of dividends is termed
as the saving of an organization. The savings of an organization depends on the rate of interest prevailing in
the market. Increased rate of interest would encourage organizations to increase savings instead of
borrowing money from loan market.

ii. Dishoarding:
Involves reduction in the money stock of an organization. Therefore, in the previous money stock, the
liquidity of money is high that can be utilized in the present time as loanable funds. The higher the rate of
interest, the more would be the money dishoarded and vice versa.

iii. Credit by bank:

Refers to the loan provided by bank to the organizations. Banks can increase or decrease the money lend to
an organization on the basis of certain criteria. The supply of loanable funds increases with the increase in
the money created by banks. The supply curve is interest elastic for loanable funds. The higher the rate of
interest, the more the bank would lend money and vice versa.

iv. Disinvestment:
Refers to the situation when the existing capital goods of an organization are reduced or the stock of the
organization is less than the previous stock. In such a condition, the fund that is used for the replacement
purposes are used as loanable funds.

According to Bober, ”Disinvestment is encouraged by the somewhat by a high rate of interest on loanable
funds. When the rate is high, some of the current capital may not produce a marginal revenue product to
match this rate of interest. The firm may decide to let this capital run down and to put the depreciation finds
in the ban market”

After determining the factors that influence the supply of loanable funds, let us study the demand for
loanable funds. The demand for loanable funds depends on investment, consumption, and hoarding of
income. Organizations require loanable funds to a greater extent for expanding the stock of capital goods,
such as machines and buildings.

The demand for loanable funds depends on the extent to which organizations require loanable funds. Interest
is the price at which the loanable funds can be bought. Organizations require loanable funds at which the net
rate of return on capital goods is equal to the rate of interest.
The higher rate of interest demotivates organizations to buy capital goods or expand their stock of capital
goods. Therefore, the demand of loanable funds is interest elastic for organizations; therefore, the demand
curve would slope downwards.

Theories of Wages

1. Wages Fund Theory:

This theory was developed by Adam Smith (1723-1790). His theory was based on the basic assumption that

workers are paid wages out of a pre-determined fund of wealth. This fund, he called, wages fund created as a

result of savings. According to Adam Smith, the demand for labour and rate of wages depend on the size of

the wages fund. Accordingly, if the wages fund is large, wages would be high and vice versa.

2. Subsistence Theory:

This theory was propounded by David Recardo (1772-1823). According to this theory, “The labourers are

paid to enable them to subsist and perpetuate the race without increase or diminution”. This payment is also

called as ‘subsistence wages’. The basic assumption of this theory is that if workers are paid wages more

than subsistence level, workers’ number will increase and, as a result wages will come down to the

subsistence level.

On the contrary, if workers are paid less than subsistence wages, the number of workers will decrease as a

result of starvation death; malnutrition, disease etc. and many would not marry. Then, wage rates would
again go up to subsistence level. Since wage rate tends to be at, subsistence level at all cases, that is why this

theory is also known as ‘Iron Law of Wages’. The subsistence wages refers to minimum wages.

3. The Surplus Value Theory of Wages:

This theory was developed by Karl Marx (1849-1883). This theory is based on the basic assumption that like

other article, labour is also an article which could be purchased on payment of its price i e wages. This

payment, according to Karl Marx, is at subsistence level which is less than in proportion to time labour takes

to produce items. The surplus, according to him, goes to the owner. Karl Marx is well known for his

advocation in the favour of labour.

4. Residual Claimant Theory:

This theory owes its development to Francis A. Walker (1840-1897). According to Walker, there are four

factors of production or business activity, viz., land, labour, capital, and entrepreneurship. He views that
once all other three factors are rewarded what remains left is paid as wages to workers. Thus, according to

this theory, worker is the residual claimant.

5. Marginal Productivity Theory:

This theory was propounded by Phillips Henry Wick-steed (England) and John Bates Clark of U.S.A.

According to this theory, wages is determined based on the production contributed by the last worker, i.e.

marginal worker. His/her production is called ‘marginal production’.

6. The Bargaining Theory of Wages:

John Davidson was the propounder of this theory. According to this theory, the fixation of wages depends

on the bargaining power of workers/trade unions and of employers. If workers are stronger in bargaining

process, then wages tends to be high. In case, employer plays a stronger role, then wages tends to be low.

7. Behavioural Theories of Wages:

Based on research studies and action programmes conducted, some behavioural scientists have also

developed theories of wages. Their theories are based on elements like employee’s acceptance to a wage

level, the prevalent internal wage structure, employee’s consideration on money or’ wages and salaries as

motivators.

Theories of Profit

1. Rent Theory of Profit:

This theory was first propounded by the American Economist Walker. It is based on the ideas of Senior and
J.S. Mill. According to Mill, “the extra gains which any producer obtains through superior talents for
business or superior business arrangements are very much of a kind similar to rent. Walker says that “Profits
are of the same genus as rent”. His theory of profits states that profit is the rent of superior entrepreneur over
marginal of less efficient entrepreneur.

According to these economists, there was a good deal of similarity between rent and profit. Rent was the
reward for the use of land while a profit was the reward for the ability of the entrepreneur. Just as land
differs from one another in fertility, entrepreneurs differ from one another in ability. Rent of superior land is
determined by the difference in productivity of the marginal and super marginal land; similarly the profits of
the marginal and super marginal entrepreneurs.

In short it is the intra-marginal lands that earn a surplus over marginal lands. So also intra marginal
entrepreneurs earn a surplus over marginal entrepreneur. Just as there is the marginal land, there is the
marginal entrepreneur. The marginal land yields no rent; so also marginal entrepreneur is a no profit
entrepreneur.
The marginal entrepreneur sells his produce at cost price and gets no profit. He secures only the wages of
management not profit. Thus profit does not enter into cost of production. Like rent, profit also does not
enter into price. Profit is thus a surplus.

Criticism:
1. According to critics there cannot be perfect similarity between rent and profit. Rent is generally positive
and in rare cases it may be zero. But rent can never be negative. When entrepreneur suffers losses profit can
be negative.

2. The theory explains profit as the differential surplus rather than a reward for an entrepreneur.

3. Profit is not always the reward for business ability. Profit can be due to monopoly or it can arise due to
favourable chance to the entrepreneur.

4. This theory maintains that there is no profit entrepreneur just as no rent land. But in practical life there is
no such entrepreneur because whether the entrepreneur has ability or not be gets profit as his reward.

5. The system of joint stock enterprise has become more important in the modern economy. The manner in
which dividends are distributed among the shareholders is not at all related to latter’s ability. Both dull and
intelligent shareholders enjoy the same dividends. In fact, the less able may secure more dividends if they
possess more shares.

6. This theory assumes that profit does not enter into price. But this is unrealistic because profit as a part of
the cost of production does enter into price.

7. Rent is a known and expected surplus. It is also a contractual payment. Profit is unknown.

8. Walker has analysed only surplus profit. But profit can be several other types.’

9. Walker failed to understand the true nature of profit. According to Walker, profit arose on account of the
ability of the entrepreneur to undertake risk. Critics point out that profit is not the reward for undertaking
risk but it is the reward for the avoidance of risk.

2. Wage Theory of Profit:

This theory was propounded by Taussig, the American economist. According to this theory, profit is also a
type of wage which is given to the entrepreneur for the services rendered by him. In the words of Taussig,
“profit is the wage of the entrepreneur which accrues to him on account of his ability”.

Just as a labourer receives wages for his services, the entrepreneur works hard gets profit for the part played
by him in the production. The only difference is that while labourer renders physical services, entrepreneur
puts in mental work. Thus an entrepreneur is not different from a doctor, lawyer, teacher, etc., who do
mental work. Profit is thus a form of wage.

Criticism:
1. The main defect of this theory is that it does not make a distinction between wage and profit. Wages are
fixed and certain, but profits are uncertain income.

2. The entrepreneurs undergo risk in production; but the labourer undertakes no such risk.

3. Entrepreneur bears the entire responsibility to organize the business, but labourer need not do so.

4. Profits tend to vary with price but wages do not vary so.

5. The labourer get his wages if he has put in the required amount of labour, but the entrepreneur may not
get profit even if he works hard.

6. Profit may include chance gain while wages do not include such an element.

3. Risk Theory of Profit:

This theory is associated with American economist Hawley. According to him profit is the reward for risk-
taking in business. Risk-taking is supposed to be the most important function of an entrepreneur. Every
production that is undertaken in anticipation of demand involves risk. According to Drucker there are four
kinds of risk. They are replacement, obsolescence, risk proper and uncertainty.

The first two are calculated and therefore they are insured. But the other two are unknown and unforeseen
risks. It is for bearing such risk profit is paid to entrepreneur. No entrepreneur will be willing to undertake
risks if he gets only the normal return.

Therefore the reward for risk-taking must be higher than the actual value of the risk. If the entrepreneur does
not receive the reward, he will not be prepared to undertake the risk. Thus higher the risk greater is the
possibility of profit.

According to Hawley the entrepreneur can avoid certain risks for a fixed payment to the insurance company.
But he cannot get rid of all risks by means of insurance. If he does so he is not an entrepreneur and would
earn only wages of management and not profit.

Criticism:
1. Risk-taking is not the only entrepreneurial function which leads to emergence of profits. Profits are also
due to the organizational and coordinating ability of the entrepreneur. It is also reward for innovation.

2. According to Carver profit is paid to an entrepreneur not for beaming the risk but for minimizing and
avoiding risk.

3. This theory assumes that profit is proportional to risk undertaken by entrepreneurs. But this is not true in
practical life because even entrepreneurs who do not take any risk are paid profit.

4. Knight says that it is not every risk that gives profit. It is unforeseen and non-insured risks that account for
profit. According to Knight risks are of two types viz., foreseeable risk and unforeseeable risk. The risk of
fire in a factory is a foreseeable risk and can be covered through insurance. The premium paid for the fire
insurance can be included in the cost of production. The entrepreneur can foresee such a risk and insures it.
An insurable risk in reality is no risk and profit cannot arise due to insurable risk.

5. There is little empirical evidence to prove that entrepreneurs earn more in risky enterprises. In a way all
enterprises are risky, for an element of uncertainty is present in them and every entrepreneur aims at making
large profits.

4. The Dynamic Theory of Profit:

Prof. J.B. Clark propounded the dynamic theory of profit in the year 1900. To him profit is the difference
between the price and the cost of production of the commodity. Profit is the result of progressive change in
an organized society.

The progressive change is possible only in a dynamic state. According to Clark the whole economic society
is divided into organized and unorganized society. The organized society is further divided into static and
dynamic state. Only in dynamic state profit arises.

In a static state, the five generic changes such as the size of the population, technical knowledge, the amount
of capital, method of production of the firms and the size of the industry and the wants of the people do not
take place; everything is stagnant and there is no change at all. The element of time is non-existent and there
is no uncertainty. The same economic features are repeated year after year.

Therefore there is not risk of any kind to the entrepreneur. The price of the good will be equal to the cost of
production. Hence profit does not arise at all. The entrepreneur would get wages for his labour and interest
on his capital. If the price of the commodity is higher than the cost of production, competition would reduce
the price again to the level of the cost of production so that profit is eliminated.

The presence of perfect competition makes the price equal to the cost of production which eliminates the
super normal profit. Thus Knight observes, “Since costs and selling prices are always equal, there can be no
profit beyond wages for the routine work of supervision”.

It is well known that the society has always been dynamic. Several changes are taking place in a dynamic
society.

According to Clark five major changes are constantly taking place in a society. They are:
(1) Changes in the size of the population,

(2) Changes in the supply of capital,

(3) Changes in production techniques,

(4) Changes in the forms of industrial organisation, and

(5) Changes in human wants.

These dynamic changes affect the demand and supply of commodities which leads to emergence of profit.
Sometimes individual firms may introduce dynamic changes. For example, a firm may improve its
production technique, reduce its cost and thereby increase its profit. The typical dynamic change is an
invention. This enables the entrepreneur to produce more and reduce costs, leading to emergence of profit.

Criticism:
1. It is wrong to say that there is no profit in static state because every entrepreneur is paid profit irrespective
of the state of an economy.

2. This theory does not fully appreciate the nature of the entrepreneurial function. If there are no profits in a
static state, it means there is no entrepreneur. But without an entrepreneur it is not possible to imagine how
different factors of production would be employed.

3. Mere change in an economy would not give rise to profits if those changes are predictable. It is only the
unpredictable, provision can be made for such changes and the expenditure can be included in the cost of
production.

4. This theory assumes the existence of perfect competition and static state. But they are far from reality.

5. Schumpeter’s Innovation Theory:

This theory was propounded by Schumpeter. This theory is more or less similar to that of Clark’s theory.
Instead of five changes mentioned by Clark, Schumpeter explains the change caused by innovations in the
production process. According to this theory profit is the reward for innovations. He uses the term
innovation in a sense wider than that of the changes mentioned by Clark.

Innovation refers to all those changes, in the production process with an objective of reducing the cost of
commodity so as to create gap between the existing price of the commodity and its new cost. Innovation
may take any shape like introduction of a new technique or a new plant, a change in the internal structure or
organizational set up of the firm or change in the quality of raw material, a new form of energy, better
method of salesmanship, etc.

Schumpeter makes a distinction between invention and innovation. Innovation is brought about mainly for
reducing the cost of production and it is cost reducing agent. Profit is the reward for this strategic role,
Innovations are not possible by all entrepreneurs. Only exceptional entrepreneurs can innovate. They are
capable of tapping new resources, technical knowledge and reduce the cost of production. Thus the main
motive for introducing innovation is the desire to earn profit. Profit is therefore the cause of innovation.

Profits are of temporary nature. The pioneer who innovates earns abnormal profit for a short period. Soon
other entrepreneurs, “swarm in clusters”, compete for profit in the same manner. The pioneer will make
another innovation. In a dynamic world innovation in one field may induce other innovations in related
fields.

The emergence of motor car industry may in turn stimulate new investments in the construction of
highways, rubber, tyresm and petroleum products. Profits are thus causes and effects of innovation. The
interest of profit leads entrepreneur to innovate and innovation leads to profit. Thus profit has a tendency to
appear, disappear and reappear.

Profits are caused by innovation and disappear by imitation. Innovational profit is thus, never permanent, in
the opinion of Schumpeter. Therefore it is different from other incomes, such as rent, wages and interest.
These are regular and permanent incomes arising under all circumstances. Profit on the other hand is a
temporary surplus resulting from innovation.

Prof. Schumpeter also explained his views on the functions of the entrepreneur. The entrepreneur organizes
the business and combines the various factors of production. But this is not his real function and this will not
yield him profit. The real function of the entrepreneur is to introduce innovations in business. It is
innovations which yield him profit.

Criticisms:
1. This theory concentrates only on innovation, which is only one of the many functions of the entrepreneur
and not the only factor.

2. This theory does not consider profit as the reward for risk-taking. According to Schumpeter it is the
capitalist not the entrepreneur who undertakes risk.

3. This theory has ignored the importance of uncertainty bearing which is one of the factors that determines
profit.

4. This theory attributes profit only to innovation ignoring other functions of entrepreneur.

5. Monopoly profits are permanent in nature while Schumpeter says that innovate profits occur temporarily.

6. This theory has presented a very narrow view of the function of the entrepreneur. He not only introduces
innovation but he is equally responsible for proper organisation of the business. As such profit is not merely
due to innovation. It is also due to organizational work performed by the entrepreneur. As it is well known,
every entrepreneur does not innovate and yet he must earn profit if he is to stay in business.

7. It is an incomplete theory because it has failed to explain all the factors that influence profit.

6. Uncertainty Bearing Theory of Profit:

This theory was propounded by an American economist Prof. Frank H. Knight. This theory, starts on the
foundation of Hawley’s risk bearing theory. Knight agrees with Hawley that profit is a reward for risk-
taking. There are two types of risks viz. foreseeable risk and unforeseeable risk. According to Knight
unforeseeable risk is called uncertainty beaming.

Knight, regards profit as the reward for bearing non-insurable risks and uncertainties. He distinguishes
between insurable and non-insurable risks. Certain risks are measurable, the probability of their occurrence
can be statistically calculated. The risks of fire, theft, flood and death by accident are insurable. These risks
are borne by the insurance company.
The premium paid for insurance is included in the cost of production. According to Knight these foreseen
risks are not genuine economic risks eligible for any remuneration of profit. In other words insurable risk
does not give rise to profit.

According to Knight profit is due to non-insurable risk or unforeseeable risk.

Some of the non- insurable risks which arise in modern business are as follows:
(a) Competitive risk:
Some new firms enter into the market unexpectedly. The existing firms may have to face serious
competition from them. This will inevitably lower down the profit of the firms.

(b) Technical risk:
This risk arises from the possibility of machinery becoming obsolete due to the discovery of new processes.
The existing firm may not be in a position to adopt these changes into its organization, and hence suffer
losses.

(c) Risk of government intervention:

The government, in course of time, interferes into the affairs of the industry such as price control, tax policy,
import and export restrictions, etc., which might reduce the profits of the firm.

(d) Cyclical risk:
This risk emerges from business cycles. Due to business recession or depression, consumer’s purchasing
power is reduced, consequently demand for the product of the firm also falls.

(e) Risk of demand:

This is generated by a shift or change of demand in the market.

Prof. Knight calls these risks as ‘uncertainties’ and ‘it is uncertainties in this sense which explains profit in
the proper use of the term’. These risks cannot be foreseen and measured, they become non- insurable and
the uncertainties have to be borne by the entrepreneur. According to this theory there is a direct relationship
between profit and uncertainty bearing.

Greater the uncertainty bearing the higher the level of profit. Uncertainty beaming has become so important
in business enterprise in modern days, it has come to be considered as a separate factor of production. Like
other factors it has a supply price and entrepreneurs undertake uncertainty bearing in the expectation of
earning certain level of profit. Profit is thus the reward for assuming uncertainty.

In the modern days production has to take place In advance of consumption. The producers have to face
their rival producers and the future is uncertain and unknown. These are uncertainties. Some entrepreneurs
are able to see it more clearly than others and therefore able to earn profit.

Criticism:
1. According to this theory, profit is the reward for uncertainty bearing. But critics point out that sometimes
an entrepreneur earns no profit in spite of uncertainty bearing.
2. Uncertainty bearing is one of the determinants of profit and it is not the only determinant. Profit is also a
reward for many other activities performed by entrepreneur like initiating, coordinating and bargaining, etc.

3. It is not possible to measure uncertainty in quantitative terms as depicted in this theory.

4. In modern business corporations ownership is separate from control. Decision-making is done by the
salaried managers who control and organise the corporation. Ownership rests with the shareholders who
ultimately bear uncertainties of business. Knight does not separate ownership and control and this theory
becomes unrealistic.

5. Uncertainty bearing cannot be looked upon as a separate factor of production like land, labour or capital.
It is a psychological concept which forms part of the real cost of production.

6. Monopoly firms earn much larger profits than competitive firms and they are not due to the presence of
uncertainty. This theory throws no light on monopoly profit.

Knight’s theory of profit is more elaborate than other theories, because it combines the conception of risk, of
economic change and of the role of business ability.

7. Marginal Productivity Theory of Profit:

The general theory of distribution is also applied to the factor, entrepreneur. According to Prof. Chapman,
profits are equal to the marginal worth of the entrepreneur and are determined by the marginal productivity
of the entrepreneur. When the marginal productivity is high, profits will be high.

Just as marginal revenue productivity of any factor represents the demand curve of a factor the marginal
revenue productivity curve of entrepreneur is the demand curve of an entrepreneur. As more and more firms
enter into the industry, the marginal revenue productivity (MRP) of entrepreneurship decreases. The slope of
the MRP curve will be negative. The supply curve of entrepreneur will be perfectly elastic under perfect
competition.

Criticism:
1. This theory is not a satisfactory theory of profit because it is very difficult to calculate the marginal
productivity of entrepreneurship.

2. Like land, labour, or capital the marginal revenue productivity of entrepreneurship is a meaningless
concept in the case of a firm because unlike other factors, there can be only one entrepreneur in a firm.

3. This theory is based on the homogeneity of entrepreneur, in an industry. Entrepreneurs differ in

efficiency. It is therefore, not possible to have one marginal revenue productivity curve for all entrepreneurs.
This theory thus fails to determine profit accurately.

4. This theory fails to explain why entrepreneurs sometimes earn windfall or chance gains and even
monopoly profits.
5. It is one-sided theory which takes into account only the demand for entrepreneurs and neglects supply of
entrepreneurs.

6. It is a static theory according to which all entrepreneurs earn only normal profits in the long- run. In the
real world entrepreneurs earn more than normal profit due to its dynamic nature.

Profit Maximisation
 An assumption in classical economics is that firms seek to maximise profits.
 Profit = Total Revenue (TR) – Total Costs (TC).
 Therefore, profit maximisation occurs at the biggest gap between total revenue and total costs.
 A firm can maximise profits if it produces at an output where marginal revenue (MR) = marginal
cost (MC)

 If the firm produces less than Output of 5, MR is greater than MC. Therefore, for this extra output,
the firm is gaining more revenue than it is paying in costs, and total profit will increase.
 At an output of 4, MR is only just greater than MC; therefore, there is only a small increase in profit,
but profit is still rising.
  However, after the output of 5, the marginal cost of the output is greater than the marginal revenue.
This means the firm will see a fall in its profit level because the cost of these extra units is greater
than revenue.

Profit maximisation for a monopoly

 In this diagram, the monopoly maximises profit where MR=MC – at Qm. This enables the firm to
make supernormal profits (green area). Note, the firm could produce more and still make normal
profit. But, to maximise profit, it involves setting a higher price and lower quantity than a
competitive market.
 Note, the firm could produce more and still make a normal profit. But, to maximise profit, it involves
setting a higher price and lower quantity than a competitive market.
 Therefore, in a monopoly profit maximisation involves selling a lower quantity and at a higher price. 
Profit Maximisation in Perfect Competition

In perfect competition, the same rule for profit maximisation still applies. The firm maximises profit where
MR=MC (at Q1).
For a firm in perfect competition, demand is perfectly elastic, therefore MR=AR=D.

This gives a firm normal profit because at Q1, AR=AC.

Limitations of Profit Maximisation

 In the real world, it is not so easy to know exactly your marginal revenue and the marginal cost of
last goods sold. For example, it is difficult for firms to know the price elasticity of demand for their
good – which determines the MR.
 It also depends on how other firms react. If they increase the price, and other firms follow, demand
may be inelastic. But, if they are the only firm to increase the price, demand will be elastic.
 However, firms can make a best estimation. Many firms may have to seek profit maximisation
through trial and error. e.g. if they see increasing price leads to a smaller % fall in demand they will
try to increase price as much as they can before demand becomes elastic
 It is difficult to isolate the effect of changing the price on demand. Demand may change due to many
other factors apart from price.
 Firms may also have other objectives and considerations. For example, increasing the price to
maximise profits in the short run could encourage more firms to enter the market; therefore firms
may decide to make less than maximum profits and pursue a higher market share.
 Firms may also have other social objectives such as running the firm like a cooperative – to
maximise the welfare of stakeholders (consumers, workers, suppliers) and not just the profit of
owners.
 Profit satisficing. This occurs when there is a separation of ownership and control and where
managers do enough to keep owners happy but then maximise other objectives such as enjoying
work.